What you should know about Interest Rates and Credit Analysis?

Before I began working career, I interpret interest rate as the return of the interest rate dependant on the deposit in the bank savings calculated every year known as Annual Percentage Rate of Charge (APR) which is useful for interpreting for non-annual duration loans. I much prefer to define interest rates as the cost of borrowing money or assets and this varies depending on the borrower (company/individual) and the economic climate.

From a lender perspective, there are several things to consider. The first step is to advertise the types of services available to the borrower and that they are aware of the types of lending. The next step is to understand the financial capacity of the borrower to be able to make payments in the future. Both quantitative and qualitative assessment forms a part of the overall appraisal of the borrower. Hence, they often asked multiple questions when applying for a loan such as a mortgage, car finance, personal loans, and business loans etc. Financial statements are often used as evidence to understand the revenue/income and their expenses and cash flow forecast or spending habits which comes from the financial statements. Financial ratios can be calculated to analyze the borrowers financial capacity.

As the lender is running a business, it is important for them to identify and assess the different types of risks and the likelihood of events occurring normally referred to as a ‘What if’ analysis or stress testing and compared with other types of investments out there for their risks in return. i.e. interest rate rises, on a variable loan would they still be able to pay back the debt? The lender can then compared with other types of investments out there for their risks in return.

Referred to as the 5 Cs

Essentially, credit analyst use information on various borrowers in deciding whether or not to make a given loan.

• Character: Known as credit history, it is the reputation of the lender from its history of any loans and whether payments were made on time and the loans are taken.
• Capital: The borrower may be able to contribute some capital toward a potential investment. The capital mitigates the loss in an event if the borrower default.
• Capacity: This in general, helps to determine the entity’s debt servicing capacity, or its ability to repay its debt.
• Conditions: -Refer to how a borrower intends to use the money.
• Collateral: Can help a borrower secure loans. It gives the lender the assurance that if the borrower defaults on the loan, the lender can repossess the collateral.

After assessing the application and using the credit analyst can provide a “go or no-go” recommendation to the lender or require to undertake further due diligence or suggest to implement any conditions to address any “red flags”.

There are different types of financing structures that the could work for the borrower and the lender. These are the main ones:

• Vanilla Payment: The typical known as interest and principal payment, whereby the end of the term you would have made payment of the principal and the interest and received some equity.
• Balloon Payment: Is know where periodic payments are low and a large sum is paid at the end.
• Interest only: Like the vanilla payment, though no principal is payment is made.

The duration and liquidity of the loan are the main factors that determine the interest rates. Commonly The Higher the Risks or Uncertainty, the Higher the Interest Rate.

• Base Rate: this is the risk-free investment where it is normally in high economic countries bond or UK-regulated current or savings account or ISAs.
• Duration of the Loan: the longer the duration the higher the interest rate and there is more uncertainty in the future.
• Liquidity of the Loan: the less liquid the loan is to withdraw the higher the interest rate is for compensation.